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Consumer and Producer Price Indices
The Consumer Price Index (CPI) and Producer Price Index (PPI) are inflationary measures used to determine whether prices for goods and services are rising (inflation), falling (deflation when below zero or disinflation when falling but still above zero), or staying the same (since there is no particular term for this, let’s just call it “zinflation,” for zero inflation). CPI is a price measure of the consumer side of the equation, and PPI measures prices for producers.
These figures are widely used by central banks to determine the course of monetary policy (though admittedly not the only ones) and can have an overarching effect on virtually all tradable markets. So let’s take a look at the “flation” aspect of these reports to see how they are interpreted.
When prices are rising or staying consistently above the 0% level, it is called inflation. In short, prices are being inflated higher each year just like blowing up a balloon. Current economic belief is that a low and stable inflation rate can help reduce the severity of potential economic downturns by enabling businesses to adjust quickly.
Central banks try to keep inflation in this range by lowering interest rates when it falls below 2% working on the belief that if capital is cheap to borrow, businesses and consumers will use that ability to buy things and keep the economic engine running. Conversely, if inflation runs over 3%, raising interest rates encourages those entities to save as they get more “bang for their buck” by keeping it in the bank.
If inflation is too low (but still above zero), you could potentially see a situation arise like what happened in Japan during the 1990s and early 2000s, a time dubbed as “The Lost Decades.” During that period, inflation remained at frustratingly low levels and the nation fell into economic complacency, failing to see an increase in GDP over long stretches. In an attempt to combat that, the Bank of Japan lowered interest rates down to 0% to encourage spending over saving, but instead many businesses and individuals chose instead to borrow at the lower rates to pay off previous debts; very little of the increased available money went into consumerism or increased business activity. In later years, Japan accelerated its easy monetary policy even further by introducing Quantitative Easing (QE), which is the process of lowering interest rates further by outright purchases of government bonds or asset-backed securities by the central bank which essentially introduces more money to the current money supply.
There are times when inflation can get a little out of control, and this is defined as hyperinflation. There are many historical examples of this situation where prices rise at extraordinarily expedient rates including France during the French Revolution, the German Weimar Republic just before WWII, Russia after the fall of the Soviet Union, Zimbabwe in the mid-2000s, and even the United States during the Revolutionary War. As you can likely tell, most of these hyperinflationary episodes ended in war or were a direct result of conflict or lack of confidence in the state’s ability to govern. Needless to say, central banks try to do anything they can to prevent this from happening, including revaluating their currency and/or raising interest rates to levels where it becomes more advantageous to save rather than borrow.
If prices are declining the term deflation is used. If you were to ask the average person on the street if they think it’s a good thing that prices are falling, you would probably get a majority of affirmative responses. Who wouldn’t want the prices of the things you buy every day to be cheaper? Well, manufacturers, for one, wouldn’t like it very much. It means that the margin they make on the products they produce would go down, which means they need to find ways to make it cheaper; and that usually leads to layoffs. If more people don’t have jobs, then less stuff is being consumed which leads to even smaller margins for producers. You can see the nasty spiral that is self-preserving here, and it only gets worse over time. To combat deflation central banks will typically try to make the act of borrowing money more accessible by lowering interest rates and making it sensible to do so. The increase in money available has the effect of decreasing the value of the currency, therefore creating inflation by way of supply.
“Zinflation” is the term we are using for when interest rates stay the same over a period of time. Back in the 1990s, the idea of zinflation was something that was debated as being the ultimate goal of central banks and even Federal Reserve Chairman Alan Greenspan expressed a desire to achieve it. Since then, the experience of Japan in the Lost Decades has served to make zinflation less desirable, as it would be likely synonymous with a lack of growth for an economy as well. Therefore, the model of low inflation near the 2%-3% level has become the preferred model to begin the 21st century.